With a generation of Baby Boomer business owners on the cusp of retirement and a favorable M&A market, 2021 is proving to be an opportune time for business owners actively considering their exit strategies. An option that is often overlooked but can offer immense benefits to a seller, depending on their transaction goals, is an Employee Stock Ownership Plan (ESOP).
An ESOP is a tax-advantaged transaction alternative to a third-party M&A sale. To realize liquidity and transition ownership, shareholders of the company have the flexibility to sell the entire business or just a minority percentage interest in the business to an ESOP. This provides a company’s workforce with an indirect ownership interest in the company (the “plan sponsor”) at no cost to the employee.
However, an ESOP is not a cookie-cutter solution that works for every company or selling shareholder. Each ESOP transaction is uniquely structured and may be more appropriate for some companies and sellers than others. To help you decide whether an ESOP is the right move for your organization, consider the following benefits and drawbacks of an ESOP versus a third-party M&A transaction.
Advantages of an ESOP
Substantial Tax Benefits
ESOP transactions can provide considerable tax benefits to the selling shareholders and the plan sponsor. When properly structured, the transaction can provide sellers the opportunity to defer and potentially eliminate a capital gains tax payment on the stock sale to an ESOP via §1042 of the Internal Revenue Code.
The ESOP ownership structure can also significantly reduce or even eliminate a company’s corporate tax burden. An annual, tax deductible contribution to the ESOP by the sponsor company can be used to repay loans made to finance the ESOP transaction. Effectively, the payments of principal and interest on the debt can be made tax deductible, subject to certain payroll-related limitations.
Your business will attain the most significant tax benefits when an ESOP owns 100% of the common stock of an S corporation. Due to the pass-through nature of S corporations and the tax-exempt status of the ESOP, 100% ESOP-owned S corporations are largely shielded from any income tax liabilities.
Maintain Control, Continuity, and Corporate Culture
Switching to an ESOP is a fantastic path for business owners who truly value the corporate culture they’ve built and wish to provide an opportunity for their employees to benefit in the long run from the economic success of the business. It also positions the owner to realize liquidity from their business but carry on with minimal disruption to the daily operations for as long as they wish before retiring. This allows the owner to retire when they reach a certain milestone or when the timing feels right.
An ESOP tends to be a best fit for:
- Owners looking for a gradual exit from the business
- Owners of family businesses hoping to continue their legacy in the company and influence its culture into the future
- Owners who are weary of selling to a third party and losing control of the strategic direction and culture of their companies
Disadvantages of an ESOP
Less Liquidity at Close
The big difference between a third-party transaction and an ESOP transaction is the amount of liquidity the seller will receive at closing. In a third-party transaction, a buyer provides liquidity to a seller. In an ESOP transaction, liquidity is often achieved by the company borrowing from a lender to finance the ESOP’s stock purchase. As lenders’ credit requirements limit the amount of debt an ESOP sponsor company can have on the balance sheet, many selling shareholders can expect one of two scenarios:
- The seller finances the difference between the debt capacity and the business’ value by taking back a subordinated note from the company; or
- The seller only sells as much equity as can be financed and retains some equity ownership in the company.
In either scenario, the seller in an ESOP transaction will receive less cash at close in comparison to the average third-party sale and will maintain some form of an investment interest in the business for some years post-transaction (either equity or a note). The seller will be subject to ongoing risk of the business over the life of their financing. Any declines in the company’s performance may impact its ability to service seller debt.
For those sellers seeking to fully diversify their personal balance sheets at the time of a transaction, selling to a third-party may be a more attractive option, as liquidity at close will likely be higher and post-transaction exposure to declines in company performance will likely be lower.
Hefty Administrative Requirements
An ESOP is a nuanced transaction that involves an employee benefit plan subject to federal law, namely the Employee Retirement Income Security Act of 1974 (ERISA), and ongoing regulations. Coordination with multiple service providers and effort from management is necessary when properly executing and maintaining an ESOP that heeds all laws.
The ESOP is a trust for the benefit of the employees that requires:
- The appointment of a trustee to act as a fiduciary of the ESOP
- The performance of annual valuations of the ESOP-owned stock
- A third-party administrator to help maintain participant accounts
- Lawyers to represent various parties
Due to the complexity and ongoing maintenance costs associated with a properly run ESOP company, businesses with less than $5 million of enterprise value and/or fewer than 30 employees should carefully consider whether an ESOP is the right solution.
ESOPs are not the right answer for all business owners but can provide a potential strategy to help sellers achieve their ownership transition goals.
Looking For Additional ESOP Insights?
Our team at SC&H Capital has years of expertise in assisting plan sponsors with the formation, administration, and execution of their ESOPs. As a 100% employee-owned company ourselves, our experts understand the complexities of implementing and managing an ESOP. For more information about ESOPs, or how SC&H Capital can support these and other transitions in ownership, please contact us.